By Sam Stovall
Standard & Poor's opinions on individual stocks, issued under our STARS system, are widely recognized in the investing community. But we also offer broader recommendations on the sector level. S&P's Sector Committee establishes recommendations of overweight, underweight, or marketweight for the 10 sectors in the S&P 1500 index based on fundamental, technical, and historical factors.
An overweight designation means that a diversified portfolio should have exposure to the sector greater than its market-cap weighting in the S&P 1500. A sector with a marketweight opinion should account for a portfolio weighting in line with its share in the S&P 1500, while one with an underweight should represent a lower percentage.
A note about these recommendations: Since they are greatly influenced by the relative count of stocks with S&P's top investment ranking of 5 STARS (buy) within each sector, rather than market-cap weightings of the underlying 5-STAR stocks, these suggested weightings are not designed to offer guidance on trading sector-oriented exchange-traded funds.
Our current suggested weightings -- as well as reasons for recent changes to our recommendations -- are as listed below. Investors can monitor BusinessWeek Online's Investing Channel for reports on future sector upgrades and downgrades.
Recommended Sector Weightings:
Marketweight: Consumer Discretionary, Consumer Staples, Health Care, Industrials, Information Technology, Materials, Telecom Services, Utilities
Here's a rundown of the sector recommendation changes S&P has made in recent weeks:
Health Care. On July 22, S&P lowered its recommendation on the sector to marketweight from overweight. In S&P's opinion, the sector faces challenging second-half comparisons, and it continues to anticipate that the pharma group, which accounts for 54% of the sector on a market-cap weighted basis, will struggle with patent expirations and decelerating growth from existing businesses.
Throughout the sector, S&P thinks foreign currency benefits will abate, and that valuations will be increasingly under pressure as the market prices in a potential Kerry victory. Based on these concerns, we recommend lowering health-care exposure to roughly 13% of a diversified portfolio, in line with its share in the S&P 500.
Information Technology. On July 13, the recommendation on this group was lowered to marketweight from overweight. After several earnings warnings from member companies for the June quarter, S&P is less optimistic about the fundamentals of -- and the price appreciation potential for -- the IT Sector. Seasonal trends, upcoming option expensing, and expiration of accelerated depreciation of some tech purchases also factor into S&P's analysis.
S&P is emphasizing subindustries that tend to do better in the later stages of technology cycles, such as Communications Equipment and Data-Processing and Outsourced Services, as well as large-cap companies with S&P quality rankings of B+ or better, such as Affiliated Computer (ACS ; recent price, $53.34), Automatic Data Processing (ADP ; $40.64) and Microsoft (MSFT ; $28.40), each of which is ranked 5 STARS.
Consumer Discretionary. The opinion on this group was downgraded on June 29, to marketweight from overweight. Although the Conference Board's Consumer Confidence Index for June was higher than expected, we believe that stock market leadership, at least in the near term, will be coming more from other sectors.
We look for upside for the discretionary sector to be dampened by the prospect of higher interest rates between now and early 2006, plus the expectation of slower growth in personal consumption expenditures in 2005. However, we still see a variety of attractive stocks in the Discretionary group, including some in the retail and advertising-related segments.
Utilities. The recommendation on this group was raised to marketweight from underweight on July 27. Given recent market turbulence, S&P expects increasing investor interest in more defensive, higher-yielding stocks. S&P sees this shift in sentiment offsetting its expectation for subpar earnings growth in the sector. With global utilities benefiting from increasing electric demand, S&P initiated coverage in July of U.S. American Depositary Receipts for Spain's Endesa (ELE ; $18.00) and China's Huaneng Power (HNP ; $32.40), each of which is ranked 5 STARS. Domestically, S&P believes utilities with unregulated investments can generate above-average earnings per share growth. Favored 5-STARS names include Constellation Energy (CEG ; $37.10) and AES (AES ; $9.70).
Energy: This sector was upgraded on July 16 to overweight from marketweight. Year to date through July 13, this was the top-performing S&P 1500 sector, up 14% vs. the index's 0.3% rise. S&P energy earnings estimates have risen this year on revisions in oil prices as Mideast tensions added a premium to already-high prices -- and demand kept global inventories low.
S&P believes sustained high oil and gas prices will continue to support investor interest. Five-STARS picks in the sector include major oil outfits Exxon Mobil (XOM ; $45.36), Chevron (CVX ; $93.99), ENI (E ; $99.23) exploration and production company Noble (NBL ); $54.20); refiner Premcor (PCO ); $37.95); and contract drillers Nabors (NBR ; $45.20), Ensco International (ESV ; $29.67), and Diamond Offshore (DO ; $23.70).
Industry Momentum List Update
For regular readers of the Sector Watch column, here is this week's list of the 12 industries in the S&P 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) and the highest STARS-ranked companies in the sub-industry index (tie goes to the largest market value) as of July 23, 2004.
* S&P's stock appreciation ranking system for the coming 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell).
Editor's note: This is an updated version of a story published earlier on BusinessWeek Online.
All of the views expressed in this research report accurately reflect the research analysts' personal views regarding any and all of the subject securities or issuers. No part of the analysts' compensation was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed in this research report.
For Required Disclosure information and Price Charts for all STARS ranked companies go to http://www.spsecurities.com, click on "Investment Research", and then click on "Required Disclosures & Standard & Poor's STARS vs. Closing Prices Charts".
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Disclaimer: This material is based upon information that Standard & Poor's considers to be reliable, but neither Standard & Poor's Investment Advisory Services LLC nor its affiliates warrant its completeness or accuracy, and it should not be relied upon as such. Assumptions, opinions and estimates constitute our judgment as of the date of this material and are subject to change without notice. Past performance is not indicative of future results.
This material is not intended as an offer or solicitation for the purchase or sale so any security or other financial instrument. Securities, financial instruments or strategies mentioned herein may not be suitable for all investors. This material does not take into account your particular investment objectives, financial situations or needs and is not intended as a recommendation of particular securities, financial instruments or strategies to you. Before acting on any recommendation in this material, you should consider whether it is suitable for your particular circumstances and, if necessary, seek professional advice.
Stovall is chief investment strategist for Standard & Poor's